The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, November 21, 2012

George Osborne defends big banks as good for UK

In his testimony to Parliament, George Osborne not only defended the idea that big banks are good for UK society, but also expressed his wish that the UK had more big banks.

I am confident that Mr. Osborne's statement will generate a number of articles and posts saying:

Hope he gets his wish and that (fill in the country's name)'s largest banks will all move there so that (fill in the country's name)'s taxpayers will no longer have to bail them out; or

How could he have offered up that myth about the need for large banks when both the recent financial crisis and academic studies have debunked this idea and shown that banks never need to exceed $100 billion in size.

What I found more interesting is his defense of the big banks rested on the observation that other countries had them so therefore the UK should too.

The fact that other countries have these banks doesn't prove these banks are good for society.

Commission member Justin Welby, the Bishop of Durham and Archbishop of Canterbury in waiting, asked the Mr Osborne why he could not simply break up big banks altogether.

Mr Osborne said he believed the survival of big banks was good for UK society.

"If we aggressively broke up all of our big banks, I am not sure that, as a society, we would benefit form it," said the Chancellor.

"There are still a lot of big banks operating in other countries. I think it is important for the UK that our largest private sector industry thrives, survives and grows, employing very large numbers of people across the UK.

"I want Britain to be the home of big successful banks. I think it would be a real shame if we were saying to the likes of HSBC that they can't locate themselves in the UK. I think that would be a mistake for us as a country.

"I think we have to strike the right balance. We want to be a home to successful financial services but we want those services to be safer."

Regular readers know that I don't think that politicians and regulators should get into figuring out how to break up the big banks.

It is far easier to break these banks up by simply requiring them to provide ultra transparency and let market discipline force them to break themselves up.

Under ultra transparency, banks would be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details. With this information, market participants could independently assess the risk of each bank and adjust the price of their exposure to reflect this risk.

As riskier banks see their cost of funding increase, they will be under tremendous pressure to reduce their risk. The easiest way to reduce risk is by getting out of the riskiest businesses.

Mr Osborne also warned the commission against attempting to rewrite the Bill so close to its passage through Parliament.

"I don't think personally this is the right moment to tear up all the work that's been done over the last two years. That would inevitably delay things and I think we have got to a good place where broadly we have a consensus," he said.

"You will be unpicking the work that John Vickers and his commissioners did. That work has been accepted, as far as I'm aware, by all the major political parties. We are now on the verge of getting on with it."

Commission members bridled at the suggestion that Mr Osborne was seeking to limit their inquiry.

Labour MP Pat McFadden told the Chancellor: "If you are worrying about the freedom and powers of the Commission, perhaps you should have thought about that before establishing it...

"If you were sitting on this side of the table, you wouldn't take too kindly to a Chancellor saying 'I want you to look at that, but not to look at that'."

Commission chairman Andrew Tyrie said the members did not find it "very convincing to be told that we should be wary of unpicking a consensus".

"Just because something has achieved a consensus does not necessarily mean that it is right. It is our job to take a look at it," said Mr Tyrie....

Please re-read the highlighted text as this is exactly what I have been saying about the proposal to substitute the combination of complex rules/regulations and regulatory oversight for transparency and market discipline.

[Mr. Osborne] also said the draft Bill was imposing a lot of cost on banks and a full separation would be an even greater cost.

"Exactly the same Members of Parliament who say we must screw the banks down are the same ones getting up and saying we have got to get the banks to lend," he said...

Mr. Osborne makes a compelling case for ending the pursuit of complex rules/regulations like ring-fencing.

It is very inexpensive to provide ultra transparency.

Equally importantly, providing ultra transparency does not impede a bank's ability to make a loan.

Mr Osborne said the primary purpose of the legislation was to ensure that, in a future crisis, a Chancellor is able to allow a bank to fail while protecting consumers, rather than being forced to bail it out, as his predecessor Alistair Darling was because of the "inadequate" legislation in place at the time of the 2007-8 banking crash.

"Ultimately, what this is all about is so that the person doing my job – hopefully not on my watch – when faced at midnight with that decision 'Do you let this very large bank go bust?' has enough confidence to say 'I think we can let it go because the banking Bill has provided me with enough reassurance that we can continue to provide core services, that people can go to cashpoints and get their money out'," said Mr Osborne.

"My predecessor, when he was faced with that decision, felt he was not confident that people would be able to get their money out of the cashpoint in the morning.

"If, at the end of all this, the person doing my job is still not confident that people can get their cash out of the cashpoint even if they let the institution fail, then I think we as a Parliament will have failed."

One of the many benefits of requiring the banks to provide ultra transparency is that it ensures that a Chancellor can feel comfortable in the middle of the night allowing a bank to fail.

With ultra transparency, market participants know they will not be bailed out. The reason they will not be bailed out is that they have access to the information they need to independently assess the risk of each bank and to adjust their exposure to each bank to what the market participant can afford to lose given the risk.

This permanently ends bailing out the banks for fear of financial contagion.

Regular readers also know that in a modern financial system there is no reason to ever bailout a bank. Banks can continue to operate and support the real economy even when they have low or negative book capital levels because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, the taxpayers become the silent equity partners of any bank with low or negative book capital levels.

Hence, until the financial regulators decide to shut down the bank, it can continue in operations.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.